Role of Insurance Companies:Indemnification, Insurer’s business model

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Management of Financial Institutions - MGT 604
Lecture # 35
Role of Insurance Companies
Insurance, in law and economics, is a form of risk management primarily used to hedge
against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk
of a loss, from one entity to another, in exchange for a premium. Insurer, in economics, is
the company that sells the insurance. Insurance rate is a factor used to determine the
amount, called the premium, to be charged for a certain amount of insurance coverage.
Risk management, the practice of appraising and controlling risk, has evolved as a discrete
field of study and practice.
Principles of insurance
Commercially insurable risks typically share seven common characteristics.
1. A large number of homogeneous exposure units. The vast majority of insurance
policies are provided for individual members of very large classes. Automobile
insurance, for example, covered about 175 million automobiles in the United States
in 2004.[2] The existence of a large number of homogeneous exposure units allows
insurers to benefit from the so-called "law of large numbers," which in effect states
that as the number of exposure units increases, the actual results are increasingly
likely to become close to expected results. There are exceptions to this criterion.
Lloyd's of London is famous for insuring the life or health of actors, actresses and
sports figures. Satellite Launch insurance covers events that are infrequent. Large
commercial property policies may insure exceptional properties for which there are
no `homogeneous' exposure units. Despite failing on this criterion, many exposures
like these are generally considered to be insurable.
2. Definite Loss. The event that gives rise to the loss that is subject to insurance
should, at least in principle, take place at a known time, in a known place, and from
a known cause. The classic example is death of an insured on a life insurance policy.
Fire, automobile accidents, and worker injuries may all easily meet this criterion.
Other types of losses may only be definite in theory. Occupational disease, for
instance, may involve prolonged exposure to injurious conditions where no specific
time, place or cause is identifiable. Ideally, the time, place and cause of a loss should
be clear enough that a reasonable person, with sufficient information, could
objectively verify all three elements.
3. Accidental Loss. The event that constitutes the trigger of a claim should be
fortuitous, or at least outside the control of the beneficiary of the insurance. The loss
should be `pure,' in the sense that it results from an event for which there is only the
opportunity for cost. Events that contain speculative elements, such as ordinary
business risks, are generally not considered insurable.
4. Large Loss. The size of the loss must be meaningful from the perspective of the
insured. Insurance premiums need to cover both the expected cost of losses, plus the
cost of issuing and administering the policy, adjusting losses, and supplying the
capital needed to reasonably assure that the insurer will be able to pay claims. For
small losses these latter costs may be several times the size of the expected cost of
losses. There is little point in paying such costs unless the protection offered has real
value to a buyer.
5. Affordable Premium. If the likelihood of an insured event is so high, or the cost of
the event so large, that the resulting premium is large relative to the amount of
protection offered, it is not likely that anyone will buy insurance, even if on offer.
Further, as the accounting profession formally recognizes in financial accounting
Management of Financial Institutions - MGT 604
standards (See FAS 113 for example), the premium cannot be so large that there is
not a reasonable chance of a significant loss to the insurer. If there is no such chance
of loss, the transaction may have the form of insurance, but not the substance.
6. Calculable Loss. There are two elements that must be at least estimable, if not
formally calculable: the probability of loss, and the attendant cost. Probability of
loss is generally an empirical exercise, while cost has more to do with the ability of a
reasonable person in possession of a copy of the insurance policy and a proof of loss
associated with a claim presented under that policy to make a reasonably definite
and objective evaluation of the amount of the loss recoverable as a result of the
7. Limited risk of catastrophically large losses. The essential risk is often
aggregation. If the same event can cause losses to numerous policyholders of the
same insurer, the ability of that insurer to issue policies becomes constrained, not by
factors surrounding the individual characteristics of a given policyholder, but by the
factors surrounding the sum of all policyholders so exposed. Typically, insurers
prefer to limit their exposure to a loss from a single event to some small portion of
their capital base, on the order of 5 percent. Where the loss can be aggregated, or an
individual policy could produce exceptionally large claims, the capital constraint
will restrict an insurers appetite for additional policyholders. The classic example is
earthquake insurance, where the ability of an underwriter to issue a new policy
depends on the number and size of the policies that it has already underwritten.
Wind insurance in hurricane zones, particularly along coast lines, is another example
of this phenomenon. In extreme cases, the aggregation can affect the entire industry,
since the combined capital of insurers and reinsurers can be small compared to the
needs of potential policyholders in areas exposed to aggregation risk. In commercial
fire insurance it is possible to find single properties whose total exposed value is
well in excess of any individual insurer's capital constraint. Such properties are
generally shared among several insurers, or are insured by a single insurer who
syndicates the risk into the reinsurance market.
The technical definition of "indemnity" means to make whole again. There are two types of
insurance contracts; 1) an "indemnity" policy and 2) a "pay on behalf" or "on behalf of"[3]
policy. The difference is significant on paper, but rarely material in practice.
An "indemnity" policy will not pay claims until the insured has paid out of pocket to some
third party; i.e. a visitor to your home slips on a floor that you left wet and sues you for
$10,000 and wins. Under an "indemnity" policy the homeowner would have to come up
with the $10,000 to pay for the visitors fall and then would be "indemnified" by the
insurance carrier for the out of pocket costs (the $10,000).
Under the same situation, a "pay on behalf" policy, the insurance carrier would pay the
claim and the insured (the homeowner) would not be out of pocket anything. Most modern
liability insurance is written on the basis of "pay on behalf" language.
An entity seeking to transfer risk (an individual, corporation, or association of any type,
etc.) becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by
means of a contract, called an insurance 'policy'. Generally, an insurance contract includes,
at a minimum, the following elements: the parties (the insurer, the insured, the
beneficiaries), the premium, the period of coverage, the particular loss event covered, the
amount of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of
Management of Financial Institutions - MGT 604
a loss), and exclusions (events not covered). An insured is thus said to be "indemnified"
against the loss events covered in the policy.
When insured parties experience a loss for a specified peril, the coverage entitles the
policyholder to make a 'claim' against the insurer for the covered amount of loss as specified
by the policy. The fee paid by the insured to the insurer for assuming the risk is called the
'premium'. Insurance premiums from many insureds are used to fund accounts reserved for
later payment of claims--in theory for a relatively few claimants--and for overhead costs.
So long as an insurer maintains adequate funds set aside for anticipated losses (i.e.,
reserves), the remaining margin is an insurer's profit.
When is a policy really insurance?
An operational definition of insurance is that it is
the benefit provided by a particular kind of indemnity contract, called an insurance
that is issued by one of several kinds of legal entities (stock insurance company,
mutual insurance company, reciprocal, or Lloyd's syndicate, for example), any of
which may be called an insurer;
in which the insurer promises to pay on behalf of or to indemnify another party,
called a policyholder or insured;
that protects the insured against loss caused by those perils subject to the indemnity
in exchange for consideration known as an insurance premium.
In recent years this kind of operational definition proved inadequate as a result of contracts
that had the form but not the substance of insurance. The essence of insurance is the transfer
of risk from the insured to one or more insurers. How much risk a contract actually transfers
proved to be at the heart of the controversy.
This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to
reengineer insurer balance sheets under US GAAP became fashionable during the 1980s.
The accounting profession raised serious concerns about the use of reinsurance in which
little if any actual risk was transferred, and went on to address the issue in FAS 113, cited
above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the
guidance it contains is generally conceded to be equally applicable to US GAAP accounting
for insurance transactions executed by commercial enterprises.
Does the contract contain adequate risk transfer?
FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a
contract create a reasonable chance of a significant loss to the underwriter for it to be
considered insurance.
9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk
in reinsurance of short-duration contracts requires both of the following, unless the
condition in paragraph 11 is met:
a. The reinsurer assumes significant insurance risk under the reinsured portions of the
underlying insurance contracts.
Management of Financial Institutions - MGT 604
b. It is reasonably possible that the reinsurer may realize a significant loss from the
Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the
present value of all costs to the PV of all income streams. FAS gives no guidance on the
choice of a discount rate on which to base such a calculation, other than to say that all
outcomes tested should use the same rate.
Statement of Statutory Accounting Principles ("SSAP") 62, issued by the National
Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the
accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62
is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar
to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed
rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is
left as a matter of judgment.
Is there a bright line test?
Neither FAS 113 nor SAP 62 defines the terms reasonable or significant. Ideally, one
would like to be able to substitute values for both terms. It would be much simpler if one
could apply a test of an X percent chance of a loss of Y percent or greater. Such tests have
been proposed, including one famously attributed to an SEC official who is said to have
opined in an after lunch talk that a 10 percent chance of a 10 percent loss was sufficient to
establish both reasonableness and significance. Indeed, many insurers and reinsurers still
apply this 10/10" test as a benchmark for risk transfer testing.
It should be obvious that an attempt to use any numerical rule such as the 10/10 test will
quickly run into problems. Implicit in the test is keeping the 10/10 that either are upper
bonds for the comment made by the SEC official therefore, the rest of this paragraph doesn't
apply. Suppose a contract has a 1 percent chance of a 10,000 percent loss? It should be
reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10
It does not appear that any brightline test of reasonableness nor significance can be
Excess of loss contracts, like those commonly used for umbrella and general liability
insurance, or to insure against property losses, will typically have a low ratio of premium
paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called
the rate on line for historical reasons related to underwriting practices at Lloyd's of London,
will typically be low for contracts that contain reasonably self-evident risk transfer. As the
ratio increases to approximate the present value of the limit of coverage, self-evidence
decreases and disappears.
Contracts with low rates on line may survive modest features that limit the amount of risk
transferred. As rates on line increase, such risk limiting features become increasingly
"Safe harbor" exemptions
The analysis of reasonableness and significance is an estimate of the probability of different
gain or loss outcomes under different loss scenarios. It takes time and resources to perform
Management of Financial Institutions - MGT 604
the analysis, which constitutes a burden without value where risk transfer is reasonably self-
Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to
the reinsurance agreements their firms undertake. The American Academy of Actuaries, for
instance, identifies three categories of contract as outside the requirement of attestation:
Inactive contracts. If there are no premiums due nor losses payable, and the insurer
is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
Pre-1994 contracts. The attestation requirement only applies to contracts that were
entered into, renewed or amended on or after 1 January 1994. Prior contracts need
not be analyzed.
Where risk transfer is "reasonably self-evident."
"Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence
excess of loss reinsurance contracts. For these contracts, a predetermined amount of
premium is paid and the reinsurer assumes nearly all or all of the potential variability in the
underlying losses, and it is evident from reading the basic terms of the contract that the
reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the
reinsurer's loss. The existence of certain experience-based contract terms, such as
experience accounts, profit commissions, and additional premiums, generally reduce the
amount of risk transfer and make it less likely that risk transfer is reasonably self-evident."
- "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note,"
American Academy of Actuaries, November 2005. ...
Risk limiting features
An insurance policy should not contain provisions that allow one side or the other to
unilaterally void the contract in exchange for benefit. Provisions that void the contract for
failure to perform or for fraud or material misrepresentation are ordinary and acceptable.
The policy should have a term of not more than about three years. This is not a hard and fast
rule. Contracts of over five years duration are classified as `long-term,' which can impact
the accounting treatment, and can obviously introduce the possibility that over the entire
term of the contract, no actual risk will transfer. The coverage provided by the contract need
not cease at the end of the term (e.g., the contract can cover occurrences as opposed to
claims made or claims paid).
The contract should be considered to include any other agreements, written or oral, that
confer rights, create obligations, or create benefits on the part of either or both parties.
Ideally, the contract should contain an `Entire Agreement' clause that assures there are no
undisclosed written or oral side agreements that confer rights, create obligations, or create
benefits on the part of either or both parties. If such rights, obligations or benefits exist, they
must be factored into the tests of reasonableness and significance.
The contract should not contain arbitrary limitations on timing of payments. Provisions that
assure both parties of time to properly present and consider claims are acceptable provided
they are commercially reasonable and customary.
Provisions that expressly create actual or notional accounts that accrue actual or notional
interest suggest that the contract contains, in fact, a deposit.
Management of Financial Institutions - MGT 604
Provisions for additional or return premium do not, in and of themselves, render a contract
something other than insurance. However, it should be unlikely that either a return or
additional premium provision be triggered, and neither party should have discretion
regarding the timing of such triggering.
All of the events that would give rise to claims under the contract cannot have materialized
prior to the inception of the contract. If this "all events" test is not met, then the contract is
considered to be a retroactive contract, for which the accounting treatment becomes
Insurer's business model
Profit = earned premium + investment income - incurred loss - underwriting expenses.
Insurers make money in two ways: (1) through underwriting, the process by which insurers
selects the risks to insure and decide how much in premiums to charge for accepting those
risks and (2) by investing the premiums they collect from insureds.
The most difficult aspect of the insurance business is the underwriting of policies. Using a
wide assortment of data, insurers predict the likelihood that a claim will be made against
their policies and price products accordingly. To this end, insurers use actuarial science to
quantify the risks they are willing to assume and the premium they will charge to assume
them. Data is analyzed to fairly accurately project the rate of future claims based on a given
risk. Actuarial science uses statistics and probability to analyze the risks associated with the
range of perils covered, and these scientific principles are used to determine an insurer's
overall exposure. Upon termination of a given policy, the amount of premium collected and
the investment gains thereon minus the amount paid out in claims is the insurer's
underwriting profit on that policy. Of course, from the insurer's perspective, some policies
are winners (i.e., the insurer pays out less in claims and expenses than it receives in
premiums and investment income) and some are losers (i.e., the insurer pays out more in
claims and expenses than it receives in premiums and investment income).
An insurer's underwriting performance is measured in its combined ratio. The loss ratio
(incurred losses and loss-adjustment expenses divided by net earned premium) is added to
the expense ratio (underwriting expenses divided by net premium written) to determine the
company's combined ratio. The combined ratio is a reflection of the company's overall
underwriting profitability. A combined ratio of less than 100 percent indicates profitability,
while anything over 100 indicates a loss.
Insurance companies also earn investment profits on "float". "Float" or available reserve is
the amount of money, at hand at any given moment, that an insurer has collected in
insurance premiums but has not been paid out in claims. Insurers start investing insurance
premiums as soon as they are collected and continue to earn interest on them until claims
are paid out.
In the United States, the underwriting loss of property and casualty insurance companies
was $142.3 billion in the five years ending 2003. But overall profit for the same period was
$68.4 billion, as the result of float. Some insurance industry insiders, most notably Hank
Greenberg, do not believe that it is forever possible to sustain a profit from float without an
underwriting profit as well, but this opinion is not universally held. Naturally, the "float"
method is difficult to carry out in an economically depressed period. Bear markets do cause
insurers to shift away from investments and to toughen up their underwriting standards. So
Management of Financial Institutions - MGT 604
a poor economy generally means high insurance premiums. This tendency to swing between
profitable and unprofitable periods over time is commonly known as the "underwriting" or
insurance cycle. [6]
Property and casualty insurers currently make the most money from their auto insurance
line of business. Generally better statistics are available on auto losses and underwriting on
this line of business has benefited greatly from advances in computing. Additionally,
property losses in the US, due to natural catastrophes, have exacerbated this trend.
Finally, claims and loss handling is the materialized utility of insurance. In managing the
claims-handling function, insurers seek to balance the elements of customer satisfaction,
administrative handling expenses, and claims overpayment leakages. As part of this
balancing act, fraudulent insurance practices are a major business risk that must be managed
and overcome.
Gambling analogy
Both gambling and insurance transfer risk and reward.
Gambling transactions offer the possibility of either a loss or a gain. Gambling creates
losers and winners. Insurance transactions do not present the possibility of gain. Insurance
offers financial support sufficient to replace loss, not to create pure gain.
Gamblers can continue spending, buying more risk than they can afford to pay for.
Insurance buyers can only spend up to the limit of what carriers would accept to insure;
their loss is limited to the amount of the premium.
Gamblers, by creating new risk transfer, are risk seekers. Insurance buyers are risk avoiders,
creating risk transfer in terms of their need to reduce exposure to large losses.
Gambling or gaming is designed at the start so that the odds are not affected by the players'
conduct or behavior and not required to conduct risk mitigation practices. But players can
prepare and increase their odds of winning in certain games such as poker or blackjack. In
contrast to gambling or gaming, to obtain certain types of insurance, such as fire insurance,
policyholders can be required to conduct risk mitigation practices, such as installing
sprinklers and using fireproof building materials to reduce the odds of loss to fire. In
addition, after a proven loss, insurers specialize in providing rehabilitation to minimize the
total loss.
Insurance, the avoiding, mitigating and transferring of risk, creates greater predictability for
individuals and organizations.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday